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PROJECT RISK MANAGEMENT - ADVANTAGES AND PITFALLS

Kenneth K. Humphreys

, PE CCE DIF

Past Secretary-Treasurer, ICEC, Granite Falls, NC, United States

Abstract

Proper project decision-making requires that risk management and risk analysis techniques be

applied in order to guide management in making better decisions. Cost estimates attempt to

define projects as single point values whereas virtually all project variables are variable and

may deviate from the values assumed in preparing the original estimate. The objective of this

paper is to demonstrate why risk analysis is necessary, and how to determine the probability

of having a cost overrun. Some pieces of risk analysis software will be described and range

estimating will be demonstrated as an effective tool for reducing risk and for determining how

much contingency to add to reduce residual risk to an acceptable level.

Keywords: risk, contingency, decision-making, cost overruns, Monte Carlo

Introduction

Risk Analysis is often performed using spreadsheets and random number generators,

best case/worst case scenarios, or sensitivity analysis. While these approaches have some

utility, if used with caution and if their limitations are recognized, it is far more practical, and

in most cases requires less effort, to use Monte Carlo software approaches. With this software

one can estimate cost overrun probability and the amount of contingency required to reduce

the overrun probability to an acceptable level. The software also enables the project

professional to explore alternate project scenarios quickly in order to determine the optimum

solution for virtually any economic decision, something which is often not practical or

feasible with manual methods. The software can provide an estimate of required contingency

to avoid overruns at any desired probability level. It can identify the required contingency for

each critical project item and it can identify those items within the estimate which contribute

most significantly to project risk, as well as those which afford the greatest areas of

opportunity.

Perhaps the most influential pioneer in the field of project risk analysis is Michael

Curran, president of Decision Sciences Corporation in St. Louis, Missouri. Curran (1976,

1988, 1989, 1998) has written extensively on project risk analysis and range estimating

approaches and developed the first major piece of software for project risk analysis, Range

Estimating Program for Personal Computers (REP/PC). Curran’s pioneering work began in

1964 and was prompted by an article in the Harvard Business Review, Jan/Feb 1964 issue

entitled "Risk Analysis in Capital Investment" by David B. Hertz.

Curran recognized that, although Hertz never used the term, the article was about

Monte Carlo Simulation and how it could be used to address key issues in the problem of

capital planning. Monte Carlo Simulation techniques had come into prominence in the 1940s

when they were used in game theory and were applied to answer a problem in particle physics

in the Manhattan Project, i.e., the development of the atomic bomb. It wasn't long before other

scientists and engineers realized the power of Monte Carlo and began applying it many ways.

But in the Hertz article Curran saw that for the first time someone was suggesting its use in

business practice. This made so much sense to Curran that in 1968 he formed Decision

Sciences Corporation which has pioneered the field of project risk analysis in the United

States.

Project Risk Management - Advantages And Pitfalls

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